EMIR: Pension funds have been granted a further two-year exemption from central clearing requirements, but what difference does it make in practice?
The European Market Infrastructure Regulation (EMIR) came into force on 16 August 2012. It imposes a number of requirements on counterparties to derivative contracts, central counterparties and trade repositories. The European Commission has recently decided to extend the exemption for pension funds from central clearing requirements for their over-the-counter derivative hedging transactions for a further two years, from 16 August 2015 to 16 August 2017. This article provides a summary of the implications of EMIR for pension schemes and comments on the practical value of the recent extension.
What does EMIR do?
EMIR imposes obligations on parties involved in derivative trades. There are additional obligations on over-the-counter (OTC) derivative trades as opposed to exchange-traded derivatives, which are traded on a regulated exchange such as the London Stock Exchange. OTC trading takes place directly between two parties, without the supervision of an exchange (inflation rate and interest rate swaps tend to be traded OTC).
Are pension schemes subject to EMIR?
EMIR classifies counterparties as either "financial counterparties" or "non-financial counterparties" – financial counterparties are subject to more stringent requirements. Occupational pension schemes are classified as financial counterparties and therefore must comply with the relevant EMIR requirements.
What EMIR obligations apply to occupational pension schemes?
Broadly, EMIR imposes the following requirements on counterparties:
- to mitigate the risks associated with OTC derivatives that are not centrally cleared;
- to report all derivative contracts to a trade repository; and
- to clear specified OTC derivative trades through a central clearing party (CCP).
All uncleared OTC derivative trades are subject to certain risk mitigation techniques. These include timely confirmation of trades, having dispute resolution and portfolio reconciliation procedures in place and posting collateral in the form of variation margin and initial margin to cover exposure in the event of default. The majority of these requirements came into force on 15 September 2013, although some counterparties have not fully complied with them in practice. New rules will be phased in from 1 September 2016 which extend the existing requirement to post collateral. They will specify details of the collateral which must be posted by certain counterparties for any non-centrally cleared OTC derivative contracts they enter into with other counterparties who are also subject to these requirements.
Counterparties must comply with the trade reporting obligation, which came into force on 12 February 2014. This means they must ensure each derivative contract is reported to a trade repository no later than the next working day after that derivative contract is entered into. A trade repository is a body recognised or registered by the European Securities and Markets Authority (ESMA) that centrally collects and maintains the records of OTC derivative trades.
Details of when the requirements will be phased in and which counterparties they will apply to can be found here: http://www.bis.org/bcbs/publ/d317.htm. The requirements also only apply to derivative contracts where both counterparties are financial counterparties or certain non-financial counterparties.
Unless the trade is subject to an exemption, an obligation to clear applies to certain types of OTC derivative contracts (as mandated by ESMA) entered into between financial counterparties and, subject to certain conditions being met, non-financial counterparties. All OTC derivatives subject to the clearing obligation must be cleared through a CCP. A CCP acts as an intermediary between the two parties to the trade, so that each party has a separate contract directly with the CCP.
Occupational pension schemes must comply with all the obligations set out above but are temporarily exempt from the obligation to centrally clear certain OTC derivatives that are used for risk-reducing purposes (see below for more details).
Temporary exemption from clearing obligation for occupational pension schemes
Until early this month, trustees of occupational pension schemes have been exempted from the central clearing obligation until 15 August 2015 provided that the derivative contract is "objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangement". In practice, this covers the vast majority of OTC derivatives entered into by occupational pension schemes. However, pension schemes should be careful when hedging risks on a portfolio basis, for example so that they do not over-hedge. This can result in a proportion of derivative trades being subject to the clearing obligation. The European Commission has extended this period of exemption to 15 August 2017.
It is unsurprising that the exemption period for occupational pension schemes to comply with the clearing obligation has been extended. The clearing obligation has stalled in practice as the industry has failed to meet the deadlines for implementation. The countdown to the clearing obligations will commence when ESMA publishes regulatory technical standards (RTS). The RTS will specify certain derivative contracts as subject to the clearing obligation. Although ESMA has published draft RTS, cross-border equivalence issues have delayed ESMA in finalising them. The RTS will also stagger the effective date of the clearing obligation depending on counterparty type and the volume of derivatives they trade. So, even without the exemption, pension schemes are unlikely to be subject to any clearing obligations until the end of 2016 at the earliest. This would initially be for a number of interest rate derivatives only and this date is looking increasingly likely to be further delayed.
Also, it has been widely recognised that the margin requirements of CCPs may be difficult for pension schemes to comply with. One of the ways in which CCPs reduce counterparty and credit risk is by requiring participants to post highly liquid assets or cash as variation margin. As most pension schemes do not hold large amounts of cash, the concern is that requiring occupational schemes to clear trades through a CCP would cause the trustees to sell assets to generate sufficient cash and that this would be detrimental to their long-term aim of providing retirement income. The intention had been to allow occupational pension schemes to post variation margin in non-cash form but no workable solutions appear to have been reached. It is possible that the exemption could be further extended to August 2018 if a solution has not been found by August 2017.
What is the value of the extension in practice?
Whilst the extension of time is good news for schemes, there is doubt over its value for schemes in practice. First, the clearing obligation may still not be effective or appropriate for most pension schemes by the time the exemption expires. Second, the risk mitigation requirement in relation to non-centrally cleared OTC derivatives to post collateral in the form of variation margin and initial margin to cover potential exposure will be phased in from September 2016. Pension schemes are not exempt from this obligation. Finally, ESMA, the European Commission and market participants have had several years to consider ways to avoid pension schemes having to convert profit-making assets into cash in order to meet CCPs' variation margin requirements. They are yet to get any closer to a workable solution. There is currently a review of EMIR by the European Commission under way, as mandated by EMIR itself. The consultation is open until 13 August 2015. The margin requirement for pension schemes is one of the topics which will feature and it will be interesting to see what the outcome is.